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In Search of Dividends

The junk stock rally is officially over. Or so says John Gould, co-manager of the Cullen High Dividend Equity Fund (CHDEX). "Last year, the 363 stocks in the Standard & Poor's 500 that pay dividends gained 26.2%, while nondividend payers gained 65.3%," he says. "Low-quality companies with no dividends and no earnings outperformed—typical for a market recovering off extreme bear market lows. But we're entering a new phase. The best performers in the last four months have been strong dividend payers."

That Gould sees paying a dividend as a sign of corporate strength should come as no surprise to anyone familiar with market history. Since 1972 the average dividend-paying stock in the S&P 500-stock index has produced an 8.5% annualized total return. That compares with 1.2% for nondividend-paying stocks and 6.8% for the S&P 500 as a whole, according to Ned Davis Research. The outperformance was achieved with one-third less volatility than with nondividend payers.

Unfortunately, the average dividend yield for stocks is 2.2%—far from the 5.4% average yield stocks paid after the last great crash in 1974. But yields are likely to pick up. With bank accounts paying almost nothing and bonds little more than 3% or 4%, investors are hungry for income. What's more, many companies that hoarded cash in the downturn are sitting on more than they know what to do with now. Cash as a percentage of total assets on corporate balance sheets was 12.5% at the end of 2009—the highest percentage on record. "Microsoft (MSFT) is sitting on $36 billion in cash," says Gould. "What is it going to do with that? I'd be surprised if it didn't announce another dividend increase before 2010 is over." (Bloomberg's dividend forecasting team, which uses seven factors to project future payouts, expects Microsoft to maintain its dividend this quarter and next, and to raise it to 14 cents per share, from 13 cents, in subsequent quarters in 2010.)

To play this trend, investors may want to consider a dividend-oriented mutual fund or exchange-traded fund. Managers of such funds generally employ one of three styles: equity-income, dividend growth and dividend capture.

Equity-income funds are usually the most conservative, seeking stable high current dividend yields. Allianz Dividend Value and American Century Equity Income (TWEIX) fall into this category. "We want companies to have sustainable dividends," says American Century's manager Phil Davidson. "We buy their stocks when they're out of favor and their yields are above average vs. their history. But first we do a lot of work analyzing their balance sheets to make sure their dividends are sustainable."

If Davidson is unsure about the sustainability of a company's dividend but still thinks it is attractively valued, he may buy its convertible bonds instead, since those securities have more downside protection. (The bonds, which are convertible into the company's stock, are senior to stocks in a company's capital structure, and so have first dibs on the company's income stream.) So though he owns common stock in steady Eddies such as AT&T (T), which has a 6.7% yield, he'd rather hold convertibles of the more fragile Bank of America (BAC) and U.S. Bancorp (USB). Davidson's defensive strategy helped limit his losses during downturns. In 2008, American Century Equity Income lost 20.1%, vs. the market's 37% slide, and its 7.9% 10-year annualized return beats 98% of its peers.

By contrast, a dividend growth manager such as Donald Kilbride of Vanguard Dividend Growth (VDIGX) cares less about current yield than the prospect for future dividend increases. "When I talk to investors, I try to get the conversation away from current yield," he says. "I'm thinking about a stock's future yield over the next five years." So his fund has a lower 2.2% yield than Davidson's 2.8%, although not much lower, thanks to Vanguard's 0.32% expense ratio.

Kilbride argues that his strategy can be less risky than equity income funds since he is not chasing the highest yield. "A lot of the high-yielding stocks in 2008 were financial stocks," he says. "We determined these were not dividend growers and that their underlying fundamentals couldn't support their current payouts." By avoiding banks and instead holding stalwarts such as shipper United Parcel Service (UPS), which has a moderate 3.3% yield but strong growth prospects, Vanguard Dividend Growth beat the broad market in 2008, falling 25%. It has beaten 95% of its peers in the past five years.

Clearly, the ideal balance would be to invest in companies with both high yields and strong growth prospects, and some funds try to do just that. Cullen High Dividend and TCW Dividend Focused combine these strategies but Cullen leans more toward equity income, TCW toward dividend growth. Other managers employ novel strategies to boost yields. The most common is called dividend capture. To "capture" as many dividends as possible, managers buy stocks right before their payouts and sell them soon afterwards, then move on to the next dividend stock.

TURNOVER TIMING

By using such a strategy, the Alpine Dynamic Dividend Fund (ADVDX) currently yields 17%. "We typically hold stocks for at least 61 days after they pay their dividends so the payout qualifies for the better dividend tax rate of 15%," says Alpine co-manager Kevin Shacknofsky. "We also buy stocks of companies right before they're about to make a special one-time dividend."

Such a strategy has risks. For one, transaction costs are typically high as managers must trade stocks to capture the dividends. Alpine's turnover ratio is 323%, more than 10 times that of Vanguard Dividend Growth. Also, such managers may have a tendency to chase stocks with the highest yields. Alpine's yield-chasing burned it badly in 2008 as the fund fell 49%. Shacknofsky says he learned from the experience. He now holds a basket of more stable blue chips such as McDonald's (MCD) and Johnson & Johnson (JNJ) in addition to his more aggressive plays.

Although high-yielding stocks with strong growth rates are rare in the U.S., they are far more common overseas, especially in emerging markets. "From 2002 through 2009, dividends in Asian stocks grew 18% per year on average, compared to just 6% for U.S. stocks," says manager Jesper Madsen of the Matthews Asia Dividend Fund (MAPIX). "Throughout that period, the yield on Asian stocks was about half a percentage point higher than U.S. stocks." Currently, he says, the average Asian stock yields 2.6%, or 3.1% if you exclude Japanese stocks.

Madsen's strategy, like that of other dividend funds, held up better in the downturn. His fund fell 26% in 2008, while the average Asia Pacific fund dropped 43%. But unlike his U.S.-oriented peers, he outperformed during last year's rally, gaining 47.6% while the average Asia fund returned only 34.7%. For dividend-hungry investors, his fund may be one where you can have your income and your growth, too.